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Date: Tue, 8 Nov 2005 11:59:29 -0500
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From: "R. A. Hettinga"
Subject: [Clips] Whither Financial Markets on the Net?
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http://www.ariadnecapital.com/journal/v5e3/outlook_whither.htm
Ariadne Capital Journal - Through the Maze Volume 5, Edition 3
Outlook
Whither Financial Markets on the Net?
by Duncan Goldie-Scot
Introduction
The economist Ronald Coase explained that firms, and banks, only exist
because of what he called 'transaction costs'. All this really means is
that firms have economies of scale. It is easier for a bank to match
borrowers and lenders than it is for each of us to do it on our own. The
optimum size of a bank, following Coase, is determined by those info
rmation costs. Banks were at their biggest and most powerful when info
rmation costs were very high. As the internet leads to plummeting info
rmation costs, banks will get much smaller - and may even be completely
unnecessary. It is not just the Zopa model (www.zopa.com) of matching
borrowers and lenders via a website but something much more revolutionary
that follows from this.
But that is running ahead of the argument. What I will do first is give a
brief overview of some of the issues in banking, look at what is on the
technological horizon, draw some lessons from the history of banking and
financial trading and then make a few predictions about where the new
technology might lead.
1. Bank payments cartel
I was chairing some e-finance conference a few years back when a director
of one of the big clearing banks said that he didn't worry about the
internet because it didn't impact on his core business - 'the management
of the money transmission network'
Payment systems are big business. According to the Boston Consulting
Group banks around the world are taking out fees of some $228 billion
dollars a year just for sending money from one database to another over
their networks. In the US about 5% of the value of an average purchase is
eaten up in payment costs. In the UK money transmission amounts to almost
1% of GDP or #4.5 billion.
Don Cruickshank, in his report Competition in UK Banking, wrote:
"Money transmission services are supplied through a series of unregulated
networks, mostly controlled by the same few large banks who in turn
dominate the markets for services to SMEs and personal customers. This
market structure results in the creation of artificial barriers to entry,
high costs to retailers for accepting credit and debit cards, charges for
cash withdrawals up to six times their cost, and a cumbersome and
inflexible payment system that is only slowly adapting to the demands of
e-commerce."
There is a reasonable defence of the payment systems cartel: the banks do
need to co-operate to make the model work: those databases do have to
talk to each other. But still, the cartel will protect its profits so
don't expect any threatening innovation to come from the banks. Paypal
caught the banks napping and they still don't know how to respond to that.
It is not just Paypal and Zopa though: there are other options emerging.
2. Historical context
If we take a very long term view, some of the underlying trends become
clearer.
Money
At the turn of the first millennium, there were many private currencies
but the quality of the coins varied enormously. For this reason coins
tended to be used locally as exchange was difficult. Trade was limited.
The commercial revolution that started round 1100 created a demand for
reputable money. The more efficient mints exploited economies of scale
and drove their less efficient competitors out of business. Governments
were not slow to take advantage of the situation. States had economies of
scale in enforcement and monitoring. They could demand payment of taxes
in the coins the state issued. Doing so helped the state to maximise
minting revenues, the tax base and its authority over local and feudal
rivals.
The dominance of state currencies took a couple of centuries to complete.
When done, states had an effective monopoly of money.
We can then roll the clock forward to, say, 1995, and contemplate the
business case for launching a private currency in the UK - perhaps called
Shillings . First one has to build enormous printing and minting plants.
One needs an army to defy the High Court and Parliament. And then we need
a huge marketing budget to persuade merchants and consumers to accept
Shillings.
It is clear that there are fairly substantial barriers to entry to the
private currency market.
But technology has struck back. Today there are various cryptographic
protocols that, with the internet, mean that I can create a currency out
of anything I like, largely for free.
I can create a glob of bits that says that I, the issuer and underwriter,
based somewhere on the net, promise to pay the bearer on demand x
Shillings. The issue cost is close to zero.
Of course, it is another matter to persuade you to accept it but the
fact remains that I can create a currency, issue a currency, circulate a
currency, offer a free and instant payment service and take $228 billion
of COSTS out of the global economy. It is only a matter of time before
someone does it. Private currencies are on their way - and it won't be
the banks in the vanguard. Mobile phone minutes, air miles, loyalty
points are all forms of money as soon as they are made fungible -
transferable.
Banking
In his books on the history of banking, Ron Chernow illustrates the
trends in banking by looking at the changing relative power of borrowers,
lenders and middlemen. In the 18 th Century Wilhelm IX, the local
nobleman and landgrave of Hesse was the heir to an enormous fortune. A
certain Mayer Amschel Rothschild used to grovel in front of this man, to
bow and to scrape. Ultimately, Rothschild was rewarded with a monopoly of
negotiating the numerous and highly lucrative state loans issued by
Wilhelm. In this case, the provider of capital was powerful. The banker
was powerless as Wilhelm could have shut him down with a grunt or a nod.
The consumers of capital, impoverished European noblemen, were also
largely powerless.
A hundred years later, in 1840, Chancellor Otto von Bismarck stayed at
the Rothschild chateau at Ferrieres during the siege of Paris in the
Franco-Prussian War. Even the Kaiser was dazzled by the wealth. Within a
century, the Rothschilds, once the obsequious servants of monarchs, had
grown to be their equal, able to thumb their noses at the Kaiser and
other minor characters on the European scene.
What happened was nationalism, the nation state. Governments have an
insatiable appetite for money for wars, economic development and
pandering to special interests. The histories of the great banking
dynasties are full of episodes in which they daringly raised money for
cash-strapped governments.
There were just a handful of these great banking dynasties. Perhaps the
greatest was J Pierpont Morgan. His forte was acting as a middleman
between British investors and American borrowers.
His power stemmed not from the millions he personally owned but from the
billions he could command or lay his hands on. The pockets of capital
were small, few and widely scattered and he became a crucial
communications node matching the two sides of the banking equation.
In the early 1900s, most US companies were small and local and were far
less known than the giant Morgan. The main thing that a Morgan could
confer on a fledgling company was not so much his capital as his cachet,
his reputation - a signal to jittery investors that they could safely
invest their money. He charged handsome fees for the privilege.
This was a man for whom brand, above all reputation, really did matter.
By 1960 the providers of capital were accumulating power over bankers in
unit trusts, mutual funds and pension funds. Companies were relying less
on the traditional banker and had a choice of different capital
instruments. For the first time in the 20 th Century the banker
middleman's power is dwarfed.
It is that shift of power that explains why 100 years ago the image
of a banker was of a rotund, grim, humourless man in late middle age
with iron-grey hair, wire-rimmed spectacles and a permanent scowl. His
role was to ration scarce credit and charge a hefty fee as the
middleman. The banker today is slight by comparison - mere salesmen
dispatched to scatter bountiful credit.
As money and credit are banal commodities the role of the banker as the
middleman between borrowers and lenders has become powerless: there are
bountiful means of exchange in an interconnected world. Even hedgefunds
are now dabbling in commercial lending.
Capital markets
The capital markets will change in a different way.
Towards the end of the 18 th century, investors would sit under the
buttonwood tree on Wall Street and gossip about the market. When it came
to trading, when a price was agreed, trading, clearing and settlement all
took place in one seamless, costless transaction. I would hand you a stock
certificate and you would hand me cash.
This model began to change when Samuel Morse perfected the telegraph in
the mid-nineteenth century. Investors became enthusiastic adopters of the
new technology, the Victorian internet, and used it to trade from afar on
the most liquid market, Wall Street. Suddenly those quaint, cheap, instant
and secure bearer transactions were open to delay, clearing and settlement
risk, repudiation, dispute and simple fraud.
The market's solution was to create an independent third party to
arbitrate errors and disputes. Therefore, we established a rule-based
clearing house, a regulatory system and a legal system to deal with
mistakes and fraud. In the market today, the ultimate error handling
routine is, 'And then you go to jail.'
This made economic sense. The advantage of having an enormous pool of
liquidity in New York or London more than outweighed the disadvantage of
having settlement delays and regulation. It was also very good for
brokers. Membership of the clearinghouse was restricted to market
intermediaries and the club or cartel was able to agree on high fixed
fees.
So, the telegraph, and the telephone, caused a seismic change in the
structure of the financial industry.
Technically we can now trade person-to-person, digital cash for digital
certificates in real time over the internet without the need for a clearing
house, without the need for a central counterparty, and without the risk
of repudiation or fraud and all achievable in a seamless, frictionless and
costless way.
Being able to do it technically doesn't mean that it will happen. But if,
as many of us believe, it is massively cheaper to do it this way, then it
almost certainly will happen. How long before someone has the courage to
issue a digital bearer bond on the internet? Their reputation really will
be on the line.
So, I see four distinct phases of trading, clearing and settlement. The
transition from each phase to the next has been caused by an order of
magnitude or more reduction in the total cost of trading, clearing and
settlement.
In phase 1, the bearer phase, traders would sit under the buttonwood tree
on Wall Street and swap bearer certificates for cash. Trading, clearing
and settlement is a single and costless transaction.
In phase 2, the advent of the telegraph means that Wall Street has to
cope with long distance orders. A regulator/clearing house has to
arbitrate disputes. Trading, clearing and settlement become three
distinct operations. The cost of sending my Securicor van to your cage,
and vice versa, is offset by the liquidity of the marketplace.
In phase 3, the mainframe computer means that we can immobilise and then
dematerialise stock into book entries in a database. Trading, clearing
and settlement remain separate operations, partly out of habit and partly
because the clunkiness of the bank payment mechanisms. Clearing and
settlement in computerised databases is cheaper than physical delivery but
is neither cheap nor simple: multiple message formats have to be
processed in a steep hierarchy of connections between participating
institutions.
In phase 4, the invention of financial cryptography and the dominance of
the internet, as a universal network, means that database entries, and
immobilised documents, can be represented in digital bearer form on the
internet. Digital cash can be exchanged for digital equity in real time
in a costless transaction. The processing can be distributed on client
devices meaning that there are very limited hardware overheads. Trading,
clearing and settlement merge again into a single transaction.
3. Conclusions
We have established that the banking cartel exercises its power today
over the money transmission network - extracting $228 billion a year in
fees. We can look forward to new models, such as Paypal, mobile phone
payment methods and many others, killing the cartel.
We have established that government control of money has slipped back to
the market: the barriers to entry for private currencies are simply too
low not to make it attractive.
We have also established that the banker's role as the middleman matching
up borrowers and lenders had its heyday perhaps 100 years ago and has
been in continuous decline.
Finally, I contend that we will return to bearer markets on the net -
digital bearer markets overturning all of our financial structure.
Because it can happen, because it will be massively cheaper, and because
there is money to be made by making it happen, it is only a matter of
time.
If you would like to know HOW to issue a digital bearer instrument on to
the internet, come along to a conference next February and learn all
about it. It is called Financial Cryptography and the website is
http://www.ifca.ai/ .
Duncan Goldie-Scot is a director of the International Financial
Cryptography Association.
Duncan Goldie-Scot ) 2005 dgs@live.co.uk
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R. A. Hettinga
The Internet Bearer Underwriting Corporation http://www.ibuc.com/
44 Farquhar Street, Boston, MA 02131 USA
"... however it may deserve respect for its usefulness and antiquity,
[predicting the end of the world] has not been found agreeable to
experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'
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--
-----------------
R. A. Hettinga
The Internet Bearer Underwriting Corporation http://www.ibuc.com/
44 Farquhar Street, Boston, MA 02131 USA
"... however it may deserve respect for its usefulness and antiquity,
[predicting the end of the world] has not been found agreeable to
experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'